Last week we started a discussion about credit spreads and entered a mock trade on the S&P 500 ($SPX). The type of credit spread we decided to enter was a bear call spread, which consists of selling a call option and buying a farther out call option. The net result is a credit that we keep as long as the underlying security stays below our breakeven point.

A credit spread can also be used with puts and is called a bull put spread. In this type of spread, we sell a put near resistance and buy a farther-out put for protection. The idea with credit spreads is to take advantage of selling premium, without the unlimited risk of selling naked puts or calls. Unfortunately, like with any trade, we will have losers and so far this has been the case with the mock trade on the SPX.

Below is the data for this mock trade:

August 26, 2003
S&P 500 ($SPX)
Sell 1 Sep03 1005 Call @ 12.50 IV=15.1
Buy 1 Sep03 1015 Call @ 9.25 IV=15.4
Credit received = 3.25
Max risk = 6.75
Breakeven = 1008.25

September 2, 2003
S&P 500 ($SPX)
1 Sep03 1005 Call @ 25.50 IV=16.1
1 Sep03 1015 Call @ 17.90 IV=15.6
Credit received = 3.25
Cost to Close = 7.60
Current Loss = 4.35
Max risk = 6.75
Breakeven = 1008.25

Obviously, the SPX broke through resistance at 1015, creating a loss for this trade. By exiting once the SPX broke out, we could have exited for much less than the max loss. As of the close of trading on Tuesday, September 2, our loss would be about 4.35. There are two ways to handle exiting a credit spread, so let’s go over them.

Some traders might prefer having an exit strategy that consists of getting out when the stock moves above resistance. In this case, a trader would have exited once the SPX broke above 1,015. At this point, a loss of about 3.25 would have been likely. Other traders might be willing to risk the max loss, realizing that over time they will win more than they lose. Remember, with credit spreads, we expect to win 67 percent of the time because this is the odds of a stock moving sideways or down when entering a bear call spread.

Though many readers might have already exited this position by now, others might still be looking for a reversal in the SPX. This is reasonable, given the level of the CBOE Market Volatility Index ($VIX) and the fact that September is normally a very tough month for equities. This being the case, we will continue to track this trade until expiration to show how a credit spread is handled.

Now, let’s have a discussion on implied volatility and how it impacts a credit spread. In general, we want a spread to have enough implied volatility that the reward to risk ratio is at least 1:3. This might seem low, but remember that we should win 67 percent of these trades even without using technical analysis. Once we are in a trade, IV fluctuations could influence the value of the trade, but not much because we are short and long options. At expiration, IV will have nothing to do with the trade because there isn’t any value for IV when there isn’t any time left. Nonetheless, for our SPX spread, the trade would gain value if IV were to rise. This is shown by looking at the Vega for the trade, which currently sits at $8.98. This means that for each percentage point move higher in IV, the trade will gain nearly $9 in value with all other variables remaining constant.

Thus, though IV can have an impact on a credit spread, don’t become too obsessed with this input. Rather, look at the data to see if a stock is going to find resistance or support and then check for the reward to risk ratio. A great way to practice these types of trades is to use Platinum and go back in time to trade credit spreads and see how they would have progressed. For any questions or comments on this type of strategy or our mock trade, please feel free to post them on my forum.

For Part I of this series, please click here.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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